Question

3. Hedging exchange rate risk You are a sales representative of an Estonian company and your job is to be the UK market. You have just reached an agreement to deliver pany and your job is to broker domestic wild berries to ust reached an agreement to deliver 80 000 kg of berries to UK at a price of ES per kilogram. The average purchase price for berries is to se purchase price for berries is EUR 2.50 per kilogram based on contracts with your suppliers. You can expect all cash flows to occur exactly one year later. Current exchan 0.8500EURGBP. a) Explain carefully what is the direction of exchange rate risk here and how this forward contract? or exchange rate risk here and how this can be mitigated using a Ppose for a moment that the interest rate in the euro area is 1.40% and in the United King comparable interest rate is 2.6%. b) Find the EUR/GBP forward rate for one year based on interest parity Calculate the profit per transaction (in EUR) based on the forward rate?

Answer 1

a]	The exchange rate risk is in the receivables, as, it would be received in GBP after 1 year and will have to be converted to EUR at the rate that would prevail at that point of time.
	The value of receivable in GBP would be 80000*5 =	£        4,00,000
	At the current spot rate, this would amount to 400000*0.85 =	€        3,40,000
	As the purchase would be in EUR, there is no risk in
	the case of that outflow, which, will also occur after
	1 year.
	The exchange rate risk in the receivables can be
	mitigated using a forward contract to sell GBP400,000
	at the forward rate.
b]	As per the IRPT,
	F = S*(1+rh)/(1+fh)
	where
	F = The forward rate
	S = Spot rate
	rh = interest rate in the price currency [Yen]
	rf = interest rate in the base currency [$]
	Substituting values, we have
	EUR/GBP = 0.85*1.026/1.014 =	€           0.8601
c]	Value of the receivable in EUR = 400,000*0.8601 =	€        3,44,040
	Less: Cost of purchases 80000*2.5 =	€        2,00,000
	Profit on the transaction	€        1,44,040